Two recent Legal Planet contributors have shared concerns about SB 775 over the last several days (Ann Carlson’s piece is here and Dallas Burtraw’s is here). We write here to provide context—economic, legal, and political—to help readers, and perhaps even these respected authors, better understand why the bill proposes to extend and evolve California’s approach to cap-and-trade. For a primer on SB 775 itself, we recommend excellent articles from James Temple at MIT Technology Review and David Roberts at Vox.

A strong carbon pricing policy is essential for achieving California’s ambitious climate target for 2030. In order to achieve a 2/3 vote to extend cap-and-trade, however, several changes to the current market design will be necessary. SB 775 is the first serious attempt to address the challenge of extending carbon pricing after 2020 and continues to be the only proposal that offers a solution to the real-world constraints facing legislators today.

The most important thing to recognize about the challenge of extending cap-and-trade after 2020 is that it will take much more effort to meet the state’s 2030 climate target, which is 40% lower than the 2020 target.

Achieving the 2020 target has turned out to be much easier than anticipated, thanks to the Great Recession, low natural gas prices, and California’s effective clean energy policies. Indeed, ARB projects that California’s emissions will fall below the 2020 target by a substantial margin. But the cap-and-trade program has suffered from low demand at quarterly auctions because there are now more permits to emit than there are emissions (and therefore demand for permits).

Were it not for the smart design choices that ARB made to avoid problems that plagued the European carbon market, the carbon price would be at or near zero. Instead, the system today operates like a moderate carbon tax with modest annual increases. California’s cap-and-trade has worked well in this context, and it should continue to do so until 2020.

The next ten years will present new challenges. Some numbers may help readers develop an intuition for the changes that are coming. In order to achieve the 2020 target, emissions in California need to fall about 1.8 MMtCO2e per year over the next few years. But in order to get from the 2020 to the 2030 target, emissions will have to fall almost ten times faster—17 MMtCO2e per year on a statewide basis.

Over the last decade, California has pursued most of the inexpensive options to reduce emissions (along with some expensive ones, too). Most notably, utilities in California have moved away from coal-fired electric power and towards a mix of renewables and natural gas in their electricity imports; those cheap reductions are now gone. After 2020, the 17 MMtCO2e a year in new reductions will have to come from improvements in the power sector that will be harder to achieve, as well as significant reductions in the transportation and industrial sectors.

Estimating the carbon price implications of the 2030 target requires confronting fundamental uncertainty in economic growth, technological progress, and future policy developments. What is clear is that prices in the carbon market will be higher. Most likely much higher. Prices as high as $100 per ton are not at all out of the question, particularly because of policy interactions with California’s other energy and climate policies.

With higher prices, managing the economic impacts to households and firms becomes much more important. Under the current system, households get modest utility rebates and trade-exposed firms get free allowances. SB 775 would extend and expand the protections for households by delivering substantial cash rebates to account for their total fuel cost increases, not just utility bill impacts. Firms would be protected by a border carbon adjustment. Despite its legal risks and administrative complexity, a border adjustment is the only functional approach to maintaining economic competitiveness at the high carbon prices necessary to achieve our 2030 targets—and one we believe ARB is uniquely capable of administering.

One of the biggest challenges facing state policymakers is how to transition into an environment with higher carbon prices. We believe the best option is to facilitate a gradual transition from low to high prices, which is what SB 775 does with its price collar. A gradual transition is particularly important to avoid the risk that the Governor will need to intervene to suspend the market—as is his or her right by statute. But markets in general don’t tend to gradually transition when expectations change. And rules that allow firms to bank allowances purchased today for use in later compliance periods mean that as soon as the legal uncertainty that clouds the current program is resolved by passage of legislation reauthorizing cap-and-trade, prices in the market will rise, possibly to very high levels.

Careful attention therefore needs to be paid not just to the magnitude of carbon price increases, but also to the timing of the changes.

Cap-and-trade needs new legislation

All of the concerns about the post-2020 market could conceivably be addressed by ARB in its current rulemaking—although they haven’t been—were it not for the fact that the legislature must reauthorize cap-and-trade by a supermajority vote. Anything less will cast the post-2020 program into deep legal uncertainty that deters firms from making the investment decisions needed to put the state on track for 2030.

New authority is needed because AB 32 authorized cap-and-trade with a unique time limitation not included for other measures. Cal. Health and Safety Code Section 38562(c) provides that ARB “may” adopt a market based compliance mechanism “applicable from January 1, 2012 to December 31, 2020.” This language strongly suggests that extending cap-and-trade beyond 2020 will require new legislation.

Since that time the voters adopted Proposition 26, which generally requires a supermajority vote for programs that raise revenue—such as a cap-and-trade program with allowance auctions. Any changes made to AB 32 that clarify ARB’s authority to use cap-and-trade after 2020 would be subject to Proposition 26, which is one reason the Governor has repeatedly called for reauthorization of cap-and-trade via a 2/3 majority vote.

Lastly, and importantly, the recent appellate decision in the Morningstar doesn’t obviate the need for a 2/3 vote. That decision applies to the current program and evaluates the voting standard question under a pre-Proposition 26 legal framework (see here for a longer explanation). And the Morningstar decision is currently being appealed to the California Supreme Court, so the case isn’t yet over.

We have been discussing the need for new legislation for more than a year (see here, here, and here), but you don’t have to take our word for it. In a recent Senate Environmental Quality Hearing, Senator Wieckowski asked ARB Chair Mary Nichols to describe ARB’s legal authority to adopt a post-2020 cap-and-trade extension without new legislation. Chair Nichols responded that she would prefer not to do so unless absolutely necessary. Enough said. To extend cap-and trade, the legislature needs to pass a new bill.

Political constraints on legislation to extend cap-and-trade

With the need for new legislation, the question becomes: how might a bill clear the difficult hurdle of a supermajority vote in both houses? While no one can say for sure how to get to 2/3, SB 775 offers a coherent theory that responds to the politics of the moment.

First, legislation has to be acceptable to environmental justice groups. Opposition from EJ groups is an important part of the reason that prior attempts at legislative reauthorization have failed, including last year’s attempts in California and in Washington State. In contrast, SB 775 has been endorsed by several prominent EJ NGOs, despite their past misgivings about cap-and-trade. Their support turns on SB 775’s prohibition on offset credits and the progressivity of its climate rebates.

Second, legislation has to confront the recent experience with SB 1, which will increase gas taxes by 12¢ a gallon in November of this year to fund transportation investments. After last month’s vote on SB 1, there is no appetite among legislators for anything that will raise gas prices in the near term. Because reauthorization of cap-and-trade with banking would do just that, SB 775 creates a separation between the pre-2020 and post-2020 allowance markets, such that SB 775 would have no economic impacts until 2021.

Third, raising fuel taxes is politically unpopular, and even if the increases come later, politicians are reluctant to take actions that could be characterized as the second gas tax increase in a single year. For this reason, SB 775 includes rebates of allowance revenue directly to households. The bill’s authors intend these revenues to be at least large enough to fully offset impacts to both utility bills and gasoline bills under the policy for the vast majority of California residents.

In contrast, ARB’s proposal to extend the cap-and-trade market would, if authorized by a “blank check” legislative extension, fall short on all of these grounds. It retains the use of offsets and would not protect low-income Californians from gasoline price impacts. It retains unlimited banking, which would lead to an immediate increase in gasoline prices. And it does not include a mechanism for rebating the bulk of the revenue back to California residents.

We remain convinced that ARB is a global leader in terms of its administrative capacity and commitment to climate policy progress, but the market design ARB has put on the table is unlikely to win the necessary votes nor ensure that the poorest Californians benefit from the transition to a low-carbon economy.

An open door for future market links

There has been a great deal of controversy over whether SB 775 would force California to “turn inward,” as some critics have put it. This view is mistaken. SB 775 creates a new cap-and-trade period that remains open to future market links with other jurisdictions, such as Quebec or Ontario.

The only new requirements for future market links are that the Governor must find (1) that the prospective linking partner has comparable minimum carbon prices, and (2) that the link would not disrupt the climate rebate to California residents. There are no additional requirements under SB 775. In fact, these new provisions mirror the existing requirement that the prospective market links have equivalent stringency; the new additions merely clarify what equivalency means under the contours of the new program. Given that none of California’s partner jurisdictions, including Quebec and Ontario, have post-2020 cap-and-trade programs, the idea that we either can or should “pre-approve” links is misplaced. If our partners adopt comparable program ambitions there is no barrier under SB 775 to replicating their links in the post-2020 period.

If anything, SB 775’s border adjustment mechanism would facilitate a broader range of linkages and cross-border partnerships. This mechanism accounts for the carbon prices imposed by other jurisdictions, which means that we can cooperate with jurisdictions that are pursuing less ambitious climate targets. Others may wish to borrow California’s border adjustment calculations for their own use as well. For those jurisdictions that share our ambitions, external market links remain viable and new opportunities to cooperate may emerge as well with partners who are just beginning their climate policies.

Getting to post-2020 carbon pricing

In conclusion, securing the votes to authorize a post-2020 carbon pricing program will not be easy. Any strategy must take account of the new reality of post-2020 climate ambition, be accomplished via legislative reauthorization on a 2/3 vote basis, and address the very real political constraints that currently exist in the California Legislature. SB 775 does all of these things and stands out as the only proposal that addresses the constraints facing the legislature.

Michael Wara is an Associate Professor of Law at Stanford Law School and a Faculty Affiliate at the Woods Institute for the Environment. Danny Cullenward is a Research Associate at Near Zero and a Lecturer at Stanford University. Both authors advise Senators Wieckoswki and De León on carbon pricing, including SB 775.

Reader Comments

Dear Michael and Danny, Thanks for this contribution. I didn’t see your views about justifications for the restrictions on carbon offsets, apart from your reference to the importance of support from EJ groups. I’m not at all a California climate policy expert, but getting rid of offsets strikes me as a huge change. Can you please share more fully why you support this change beyond the political advantage of EJ groups’ support?

The reasons for not including offsets in the SB 775 proposal do indeed have to do with political support – the need to get to 2/3 in the legislature. Moreover, there is a strong sense that too often, offsets essentially substitute co-benefits in a forest for co-benefits in an EJ fenceline community. The policy rationale is also weaker for offsets under SB 775 – offsets are not as necessary because the price collar sets an upper limit on cost.

That being said, there’s no reason that a system could not be created to accomplish the goal of creating reductions outside of the cap that are financed by the program. For example, as under Waxman-Markey, a funding source – perhaps from the sale of allowances in excess of the cap at the price ceiling – could be created that would pay for reductions in uncapped sectors either within California or elsewhere in the US or partner jurisdictions. Given the higher carbon prices under the post-2020 system, this might actually be more cost effective in terms of harvesting additional reductions.

Hi Jim,
Thanks for your comment. I agree with Michael and would add that additionality remains a serious concern with carbon offsets. Shifting away from using offsets as a means of satisfying program compliance obligations and towards a system where some modest funds are used to pursue maximum benefits has the added value of avoiding the additionality debate.
Best, Danny

I continue to find it quite surprising that no one is willing to challenge the 2/3rds majority requirements. They are taken as immutable. It is time to get CA out from under the yoke of this stranglehold, passed at a very different time in the state. Well cast, smartly marketed, and justly organised, 2/3rds majority vote can be overturned. Without such change, the state will continue to struggle to achieve its ambitions. The super majority requirement is not democratic, and hampers change.

While I agree that the 2/3 requirement is restrictive, I don’t think it’s fare to say that it was enacted at a different time. In fact, the 2/3 requirement at issue here stems from Proposition 26, enacted in 2010. Just to be positive on this front, it wasn’t too long ago that California’s annual budgets had to be enacted by a 2/3 vote of the legislature. That led to annual crises including issuance of IOUs to state employees. The voters fixed that the same year they added Proposition 26.

I also agree with you—the supermajority requirements are undemocratic, but they are codified in the California Constitution and that’s the law.

Michael is right that the new and more strict Proposition 26 standards come from a 2010 ballot initiative. These build on and tighten the famous voting requirements from Proposition 13, which the voters passed back in 1978. It’s interesting to note that the Prop 26 standards passed in the same year California voters rejected an industry-funded initiative (Prop 23) to shut down California’s cap-and-trade program by a 23-point margin.

For more on the legal history of these standards and how state courts have interpreted them, I’d refer you to an article my co-author Andy Coghlan and I wrote:

I think that banking with discount (flow) control can transparently and predictably adjust the value of an allowance based on its vintage and whether it is drawn from the cost containment reserve. This will avoid the problems you anticipate and improve the program’s performance.

Your premise is that the price will rise to the price ceiling. While I understand why some modelers have conjectured this, and while I don’t think this will be the result (for reasons I discuss below), I agree that the program design has to accommodate this possibility. This leads to your suggestion of no banking between the current program, and no inter-annual banking in the new program. I follow your reasoning, but….

It is similarly possible in principle that the price will not be at the price ceiling, but will reside between the ceiling and floor, a corridor that widens by $5 every year to be quite wide by the end of the decade. While I think it is most likely that the price will be near the price floor fifteen months into the new program and thereafter, I realize others including good economists at Berkeley using VAR methods suggest that a price in the corridor is unlikely, at least in the current program. Nonetheless, if prices are in the corridor there would be substantial cost savings if firms could smooth inter-annual price changes and plan their investments taking advantage of inter-temporal flexibility through banking.

A strong program design should accommodate the full range of possible eventualities. Banking is valuable to reduce costs and guard the program against price fluctuations, especially if prices are in the corridor after 2021. It is also essential to make sure the current program remains successful through 2020 and all possible cost effective emissions reductions (and associated air quality improvements) are realized. These goals can be achieved by applying a discount rate to adjust the value of an emissions allowance that is banked between the current and the new program, such that there is no windfall profit and the allowance overhang in the private bank does not enable emissions that undermine the goals in the new program.

A similar approach can be applied on an inter-annual basis to any allowances that are purchased at the price ceiling. Those allowances could be designated “last out” of a holding account, meaning that all other allowances have to be used first to prevent strategic behavior, and they could be discounted to reflect the $10 annual change in value associated with the change in the price ceiling. ARB is well placed to develop this aspect of the program design.

I think the price is more likely to be near the price floor than the price ceiling for several reasons, including additional measures likely to be taken by local and state policymakers, behavioral change and promised technical innovation. But it doesn’t matter if I am wrong. Banking with this discount (flow) control will endow the program with more flexibility resulting in less cost without bad environmental consequences. In fact, banking may reduce the draw on the price ceiling in any given year and have environmental benefits.

Finally, the bottom line is that linking with other programs is likely to hinge on emissions banking. Preserving those relationships is important.

Thanks for these detailed suggestions. Michael and I look forward to talking further with you.

Just to be clear, we do not assume prices will be at the price ceiling. Rather, we think there is a reasonable chance of that happening. But we could get lucky on technological progress, as you suggest, and much depends on the other programs ARB and the state develops. Even if we ultimately end up at the price ceiling, where prices would start under SB 775 have a lot to do with how ARB would set the post-2020 cap levels, so whatever one’s outlook, I agree that the program needs to be able to manage a transition from one potential equilibrium to another. I am grateful for your thoughts about how to make intra-post-2020 banking work with a rising price ceiling.

On your suggestion related to banking between the current program and the post-2020 proposal, I think it’s worth pointing out that any banking between today’s over-allocated system—where surplus allowances do not represent real emission reductions because emissions in covered sectors are below the cap—comes at some expense to the environmental integrity of the post-2020 system. I believe the primary political constraint will be ensuring that there is no short-term price energy price increase as a result of this aspect of market design, but I think we should keep in mind that inter-period banking has environmental integrity policy implications that deserve our explicit recognition.

Another consideration is that the kind of inter-period banking you suggest would improve pre-2020 revenue outcomes by raising demand for allowance during this period, but would do so at the expense of post-2020 revenue stability—depending on the technical details and timing of any banking rules, of course. So there is a trade-off here with both positive and negative impacts.

You mentioned that SB 775 is needed in part because the statutory language relating to a market based system under AB 32 was time limited to 2020. Doesn’t the broad discretion for any “rules or regulations” under SB 32 give the ARB quite a bit of latitude to meet the 2030 targets (particularly in light of the legal precedent on agency deference?)

My read on this would be that AB 32 does grant broad authority that a court would defer to unless there were something specific, such as a time limitation for a particular approach, that limits the authority. Basically a court would try to give meaning to both the broad grant and the specific time limitation. The question that would have to be answered if ARB can extend cap-and-trade beyond 2020 is why the legislature included this language in AB32 and what it does if it doesn’t limit the authority in some way.

Having said this, I fully admit that a court might reach a different conclusion. But simply having to have this argument will be so corrosive to the cap-and-trade that I think we shouldn’t go there if it is at all possible to avoid it. Ultimately, the cap-and-trade has to have sufficient regulatory certainty that firms can invest. A lawsuit over Sec. 38562(c) is the polar opposite of that. We have to get a bill done. It needs to be everyone’s priority.